Michael Beaton, managing partner at Derivatives Risk Solutions (DRS) assesses whether ISDA’s proposals for consistent recovery and continuity frameworks for central counterparties is far reaching enough.
Is the International Swaps and Derivatives Association’s (ISDA) proposed recovery and continuity framework for central counterparties (CCPs) far reaching enough? To consider this, we have to first remember that recovery and resolution planning measures really only reduce the probability of a CCP failure. By and large they don’t address the impact of a CCP failure. In theory they should be enough, at least in most circumstances, but in practice I think it’s probably important to look at the ability of the CCP that actually executes the default management plan. Generally, this requires non-defaulting clearing members to second traders to the CCP to analyse defaulted positions and to manage the auction process which is obviously central to the CCP’s prospect of recovery.
It is important to bear in mind that as the number of CCPs increase over the years, the potential squeeze on resources becomes more acute which is why currently CCPs are seconding traders from each bank based on a type of rota system. Of course, a big clearing member who was to default is likely to be a member of several CCPs, so you have the prospect that if more than one default management process is being conducted at any one time it’s likely to place a significant burden on other clearing members which are members of all of those CCPs.
Also, the number of clearing members is growing as the capital requirements to become one decreases. It could be argued that this increases the likelihood of default and that some banks may be less equipped because they do not have the resources or scale to participate in the auction process following a clearing member’s default.
There are also other relevant factors such as the defaulting clearing member may provide other services to the CCP which might render that CCP particularly vulnerable to the default. For example, the clearing member may be a liquidity provider or perhaps the depository bank, custodian or settlement bank.
It doesn’t even really stop there. You would also need to bear in mind how the default waterfall itself is structured and designed and if it will place too much of a burden on clearing members. In theory it could act as a vehicle for the transmission of systemic risk and place too much stress on the clearing member resulting in insolvency which doesn’t really help anybody.
One question to ask is if we will ever get away completely from the issue of state-backed guarantees, even if they are only implicit? It’s just my opinion, but I think it’s doubtful. I believe these institutions really are the new ‘too big to fail’.
Resolution may not be a realistic option, for instance, because it’s not as easy to transfer the business of one CCP to another. However, that means that when recovery fails, as it could, there really are not that many options left but state-backed support. It may then be necessary for the industry as a whole to conduct more research into ‘thinking the unthinkable’ and planning for CCP resolution.
What can you do in these circumstances? Some options would be to include stress-testing of CCP financial resources – I think regulators on both sides of the Atlantic are going to be discussing the need for this – as well as higher levels of pre-funding and greater contributions by CCPs. There has also been some talk about a separate recapitalisation fund, backed by the CCPs and the clearing members, which is held in escrow and used basically as money to be bailed in, in the event of a CCP reaching the end of its default waterfall.
Last but not least, there have been some interesting conversations about possible insurance policies being placed at the end of the default waterfall as kind of a ‘last firewall.’ Whether or not that would actually exacerbate the issue around interconnectors and contagion has to be seen.
In general, I think what we need to take away from all of this is that systemic risk can be transferred – it’s arguable whether or not it can be reduced – but it certainly can’t be eliminated, and the clearing model that we are working towards is a hub and spoke which concentrates risk on a very, very small number of names.
A decentralised network is arguably stronger than a hub and spoke model, mainly because open systems are generally regarded as more robust than closed ones. The latter is what the clearing model operates on and you have that single, glaring point of failure, and there’s really no escape from that.
So, going back to the original questions – do I think the proposals are enough? I think it goes a long way, but fundamentally I don’t think it will ever resolve the problem of ‘too big to fail’. I’m just not convinced it’s a problem that is capable of resolution.
See more on this topic via the Feb podcast “What If a CCP Fails” – http://development.derivsource.com/content/what-if-ccp-fails